Tuesday, December 8, 2015

The illusion of skill - I

In every work of genius we recognize our own rejected thoughts: they come back to us with a certain alienated majesty. - Ralph Waldo Emerson

Daniel Kahneman won the Nobel Prize in economics even though he is a psychologist, not an economist. His two papers (along with his colleague Amos Tversky) - "Judgment under uncertainty: Heuristics and biases" and "Prospect theory: An analysis of decisions under risk" - had a big impact in diverse fields like economics, philosophy, military strategy, etc. When he was once asked to summarise his work in seven words, he said that five will do - 'Endlessly amused by peoples' minds.'

His book Thinking, Fast and Slow questions the peculiar assumption that most economists have that actors in the economy are rational and selfish. (If they were, I wouldn't have survived for 16 years in relative comfort.) It is useful to assume that humans are sometimes part of the mix. Assuming human rationality is like assuming a frictionless surface in introductory physics: it is fine for introducing some basic concepts before complications are introduced into the model for a closer approximation to reality. As Kahneman writes in his book while discussing prospect theory:

The standard concepts and results that undergraduates are taught are most easily explained by assuming that Econs do not make foolish mistakes.

[SNIP]

In some contexts, however,...the Humans described by prospect theory are guided by the immediate emotional impact of gains and losses, not by long-term prospects of wealth and global utility.

(In his book Nudge, the behavioural economist Richard Thaler says that economists and psychologists seem to be studying two different species: Econs and Humans. The Econs of economists 'can think like Albert Einstein, store as much memory as IBM's Big Blue, and exercises the will power of Mahatma Gandhi'. But real people or Humans studied by psychologists 'have trouble with long division if they don't have a calculator [esp. if you are American - Suresh], sometimes forget their spouse's birthday, and have a hangover on New Year's Day'.)

Kahneman is not impressed with the stock-picking skills displayed by investors. He says that an entire industry has been built on an illusion of skill. Many investors lose regularly by trading, 'an achievement that a dart-throwing chimp could not match'. He cites a study by a student of his, Terry Odean, a Finance professor at UC Berkely, who studied the trading records of 10,000 brokerage accounts of individual investors covering nearly 163,000 trades over a 7 yr. period.

Odean then chose those cases where an investor sold some stock and immediately bought another stock. This showed that the investor expected the stock that he bought (most investors were men) to do better than the stock he sold. Odean followed the stocks for 1 year after the transaction and found that, on average, the stocks that were sold did better than the stocks that were bought by 3.2%/yr after taking into account the transaction costs. Thus for the majority of investors, it would have been better to do nothing. Kahneman writes:

...it is clear that for the large majority of individual investors, taking a shower and doing nothing would have been a better policy than implementing the ideas that came to their minds. Later research by Odean and his colleague Brad Barber supported this conclusion. In a paper titled "Trading Is Hazardous to Your Wealth," they showed that, on average, the most active traders had the poorest results, while the investors who traded the least earned the highest returns. In another paper, titled "Boys Will Be Boys," they showed that men acted on their useless ideas significantly more often than women, and that as a result women achieved better investment results than men.

This reminds me of a game that was played by the students when I was at IIMA. The students had some virtual money which they could use to invest in stocks. Whoever ended with the maximum wealth at the end of a given period was the winner. The person who won the game was one who invested in one stock on the first day and didn't do anything else for the remainder of the period. The others, who bought and sold stocks using various strategies, were left behind.

PS: What is obvious is not always true and what is true is not always obvious. In Descartes' Error, Antonio Damasio illustrates why a person with only reason and no emotion struggles to make good decisions. Psychologists refer to emotions as 'lubricants of reason'. Here is a talk by Damasio on human decision making.

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About Me

I am an Engineer/MBA forced into early retirement. In 1999, at the age of 32, I suffered a brain stem stroke which left me a quadriplegic without speech. This blog is mainly about my life after the stroke.